Validity of Pre-IPO VAM Agreements in China

Examples of typical VAM arrangements include those that provide, among other conditions, that should the target company fail to reach an agreed performance target, or go public within an agreed period of time or at a minimum offering price, etc.:

For example, the Department of Public Offering Supervision of CSRC clarified in its Questions and Answers on IPO (first issued in March 2019 and revised in June 2020) as follows:

Some institutional investors entered into a VAM agreement when investing in the issuer. What shall an issuer or intermediary do with it?

Answer：If any private equity, venture capital, or other institutions enter into a VAM agreement when investing in the issuer, as a matter of principle, the issuer shall terminate such agreement before applying for IPO, unless the VAM agreement meets all of the following criteria:

The issuer shall disclose the details of the VAM agreement, its potential implication on the issuer, etc., and flag risk alerts in the prospectus.

The above rules have also been adopted by the Shanghai Stock Exchange in its Questions and Answers on Examination of the Issuance and Listing of Stock on the Science and Technology Innovation Board (II) issued in March 2019, and by Shenzhen Stock Exchange in its Questions and Answers on Examination of the Issuance and Listing of Stock on ChiNext issued in June 2020.

In response to the above listing rules, the following approaches have been developed:

In the above cases, the courts unanimously decided that, on the basis of party autonomy and in the absence of any violation of mandatory provisions provided by laws or administrative regulations, the VAM agreements at issue were valid and enforceable. The rationale behind the courts’ opinions is probably that the enforcement of such VAM agreements will not give rise to any regulatory concerns associated with listed companies.

Contrary to the Orbita Case, recent decisions of the Shanghai High People’s Court and the Maoming Intermediate People’s Court (Maoming Court) suggest that secret VAM agreements could be invalid and unenforceable.

In Nanjing Gaoke Xinchuang Investment Co., Ltd. v. Fang Yongsheng et. al (Case No.2021 Hu Min Zhong No.569) and Nanjing Gaoke Xinjun Growth I Equity Investment LLP v. Fang Yongsheng et. al (2021 Hu Min Zhong No.745) (collectively the “Gaoke Cases”), the secret VAM agreement at issue, which provided for a pricing mechanism directly based on the stock price in the secondary market, was declared invalid by Shanghai Second Intermediate People’s Court (Shanghai No.2 Court). In the subsequent appeal proceedings, the decisions of the Shanghai No.2 Court were affirmed by the Shanghai High People’s Court.

The Shanghai No.2 Court began by revisiting the prevailing judicial opinions on VAM agreements, and admitted that VAM agreements between shareholders and investors, like one in this case, would be valid as a matter of principle. However, after analyzing the following peculiarities of the case, Shanghai No.2 Court decided otherwise:

Eventually, the court denied the validity of the VAM agreement at issue on the ground that it was detrimental to the order of the securities market and social and public interests, and violated public policy and good morals.

Similarly, in Chenbiao v. Guangdong Gaoci Technology Corporation Limited and Zou Guokui (2021 Yue 09 Min Zhong No.36; the “Gaoci Case”), the Maoming Court also declared a secret VAM agreement invalid and unenforceable. Taking a slightly different approach from the Gaoke Cases, the Maoming Court emphasized that the secret VAM agreement should have been “disclosed” rather than “terminated”, prior to the target company’s IPO:

(1) the target company should have disclosed truthful and full information about VAM arrangements according to the listing rule of the National Equities Exchange and Quotations (FAQs on Stock Issuance by Listed Companies (III)), whereas the target company made misrepresentations in this regard, as a result of the dishonesty of its shareholders and investors;

Both the Shanghai No.2 Court and Maoming Court highlighted the violation of listing rules by the parties to the VAM agreements at issue, and concluded that the VAM agreements were invalid for violation of “public policy and good morals”.

While the legal authorities for invalidating these VAM agreements are not yet known, the courts are likely to have relied on Article 153(2) of the General Provisions of the Civil Law (民法总则), which states “civil juristic acts that are contrary to public policy and good morals shall be invalid”. The courts were less likely to have relied on Article 153(1) of the General Provisions of the Civil Law, which states “civil juristic acts that violate mandatory provisions on validity provided by laws and administrative regulations shall be invalid”, because the listing rules referred to in these cases are merely department rules, rather than laws and administrative regulations. The courts’ analysis is also consistent with Article 31 of Jiu Min Minutes, which states “the violation of department rules will not affect the validity of contracts in general, unless such department rules concern financial security, market order, macro policies of the state and other public policy and good morals”.

Both cases have highlighted the risk of non-conformity with regulatory norms even if they are not laws or administrative regulations.